SYNOPSIS: Poor Argentina, slashed by Financial Markets despite trying to hold down by inflation

Argentina used to be a place of legendary political irresponsibility, where generals in funny hats declared war on Margaret Thatcher, and populist politicians who promised paradise consistently delivered hyperinflation instead. But over the past 10 years President Carlos Menem has steadily turned the country's reputation around. Inflation has been eliminated, with the peso securely pegged to the dollar. An absurdly inefficient system of protected markets and money-losing public corporations has been liberalized and privatized, producing a fair bit of unemployment but a huge surge in productivity. And as recently as five or six months ago the country was the darling of the business press, praised for its success in riding out the world's financial storms.

As usual, however, good press was the sign that things were about to take a turn for the worse. For a variety of reasons, including the devaluation in neighboring Brazil, Argentina has been sliding into a moderately severe recession and with it a growing budget deficit, just as a presidential election approaches. And in apparent desperation over his lag in the polls, Eduardo Duhalde, the Peronist candidate--the candidate, in other words, of Menem's party, which brought Argentina its unaccustomed stability--startled everyone by announcing his intention to discuss possible debt relief for Argentina. Not with the banks, mind you, but with the pope. (The pope has recently joined the call for debt forgiveness for poor nations, but he was surely talking about Fourth World economies such as Mozambique, not relatively well-off places such as Argentina.

You have to admit that it is pretty funny. Surely the Monty Python cast is about to leap into view, shouting 'Nobody expects the Spanish Inquisition!' But somehow, the markets didn't appreciate the humor: The Buenos Aires stock market plunged, and the interest rate on Argentine bonds soared

The odds are that this whole affair will soon blow over. But even assuming that the peso holds and that things don't fall apart, there is still a serious lesson in Argentina's current travails--namely, that you can scratch one more supposed economic panacea off your list. For Argentina has been the role model for those who believe that a credibly stable currency is all you need to promote prosperity. And its troubles--especially the contrast with the unexpectedly good news from Brazil--are therefore a reminder that, as John Maynard Keynes pointed out way back in the 1920s, a strong currency and a strong economy are by no means the same thing

Now, Argentina does, by law (the so-called 'convertibility law',) have an undeniably strong currency. A peso is worth a U.S. dollar, and that promise is made credible by the legal requirement that every peso in circulation be backed by a dollar's worth of foreign exchange reserves. In other words, short of actually abandoning its own currency in favor of the U.S. dollar--a measure that has been discussed quite a bit lately--Argentina has done everything possible to make that currency credible and secure. This 'currency board' system was introduced in 1991, when hyperinflation was a recent memory and most people expected it to return in due course, and you can make a reasonable case that Argentina should stick with its currency board for some time to come. (Domingo Cavallo, who as finance minister was the architect of the board, suggested a few months back that it should endure for a decade or so.) But you can no longer brush off the argument that the system is a sort of economic straitjacket, one that is becoming increasingly onerous.

The problem, you see, is that the same rules that prevent Argentina from printing money for bad reasons--to pay for populist schemes or foolish wars--also prevent it from printing money for good reasons such as fighting recessions or rescuing the financial system. Argentina came very close to financial collapse in 1995 when it turned out that the convertibility law left no leeway to rush cash to troubled banks. It has since established various safety nets to prevent a repeat of that crisis, but some observers doubt whether those nets are really strong enough. And now the country faces what is basically a garden-variety recession, the sort of thing that happens to every economy now and then--except that unlike the United States, or even a similar-sized First World country such as Australia, it cannot try to cushion the slump by lowering interest rates and pushing more money into the system.

Now, these problems with a rigidly fixed exchange rate are not news. But for a while, currency-board enthusiasts managed to convince themselves that they weren't significant. They argued that as long as governments themselves followed stable policies--and as long as the economy was sufficiently 'flexible' (the all-purpose answer to economic difficulties)--there would be few serious recessions.

But it turns out that history does not stop just because the currency is stable. And faced with a politically inconvenient recession, the Peronists find that there is nothing they can do. They cannot print money. They cannot even borrow money for some employment-generating public spending, because fiscal indiscipline would undermine the peso's hard-won credibility. You can understand why Duhalde might be tempted to appeal to a higher authority.

Of course, Argentina's economic team still believes that its system is better than the alternatives. The more sensible advocates of currency boards and, if necessary, dollarization, have always based their views less on hope than on fear--fear that any attempt to fight a recession by devaluing would lead instead to a surge in inflation and a financial collapse. But, as it turns out, their fears may have been almost as overstated as their hopes. When Brazil--whose economic history is nearly as dismal as Argentina's--finally devalued in January, the predicted hyperinflation never arrived and neither did the financial meltdown. Indeed, it is starting to look as if the collapse of the real was just what the doctor ordered.

The serious lesson of the antics in Argentina, then, is that the big issues of monetary economics--fixed vs. flexible exchange rates, whether countries should have independent currencies at all--are still wide open. It's an eternal controversy, and not even the pope can resolve it.